The Meridian is the official blog of Scott Dauenhauer and Meridian Wealth Management. This blog will update you on financial planning and investment management topics. It will also explore the impact of world events on your portfolio.

Thursday, October 22, 2009

Both articles support my position that we've allowed to much systemic risk to be placed in too few organizations. No financial institution should be Too Big Too Fail. We should not regulate "systemic" institutions we should break them up.

Wednesday, October 21, 2009

The Federal Reserve is on track to spend (read print money) to buy $1.25 Trillion in Government Agency bonds (Fannie, Freddie) in an effort to keep mortgage rates down - subsidy number 1. The government is giving away $8,000 to first time home buyers if they close before November 30th, 2009 - subsidy number 2. The mortgage interest deduction, subsidy number 3. The capital-gains exclusion, subsidy number 4. Fannie and Freddie provide liquidity to the market, but are guaranteed by taxpayers, subsidy number 5. The FHA and their 3% down mortgages......subsidy number 6.

My point.....the government has helped to create the housing bubble and they are attempting to do it again by threatening to extend or expand the tax credit for buying a home (Democrats and Republicans support this). The linked to Barron's story has the following analysis from the Brookings Institute:

According to estimates by Ted Gayer at the Brookings Institution, each additional home sale generated by the $8,000 first-time homebuyers' tax credit actually costs the government $43,000.

How's that possible? Gayer figures that of the 1.9 million homebuyers that will get the $8,000 tax credit, 85% would have bought a house anyway. The price tag of $15 billion -- about twice what Congress had intended -- he reckons will result in approximately 350,000 additional home sales, at a price tag of $43,000 for each additional sale.

That's nothing compared to the tab for a possible one-year, $15,000 tax credit for all home buyers (except those with high incomes.) Gayer figured that would cost the Treasury $73.9 billion, which he estimated would increase house sales by a total of 253,000. Each of those extra home sales would cost the Treasury $292,000 ($73.9 billion divided by 253,000.)

Monday, October 19, 2009

In a previous post I blasted the record 2009 bonuses about to be paid out on Wall Street, bonuses which are based upon revenue that could only have been generated thanks to taxpayer funded bailouts. The government is focusing on executive compensation though and has just stripped Ken Lewis of his 2009 income (don't cry for him just yet, he'll retire with about a $50 million package). It bothers me though that the government is involved in compensation, if it weren't for the fact that I believe the financial system is simply just a ward of the state at the moment I would be more bothered.

What really is irritating though is the fact that Derivatives, specifically Credit Default Swaps are not garnering more attention. Buffet once called derivatives "financial weapons of mass destruction" and 2008 proved him correct. However, instead of waging war on the enemy (derivatives) we are waging it on executive compensation (which is miniscule in terms of risk).

I don't want derivatives banned, instead I want them regulated in a manner that makes sense. Making sense means that the issuance of a derivative product cannot make your company a systemic threat to the financial system. It means that if you issue an insurance policy you better have reserves to pay for it (Credit Default Swaps are nothing more than a life insurance policy on a company, if the company dies (goes bankrupt) it pays out). CDS should not be allowed to be used for speculation, only hedging (there is more to this as I do understand that in order to be offered a hedge someone must take the opposite side of the trade, which is usually a speculator, but I'm trying to keep things simple here).

What I'm trying to get at is that we shouldn't have a dozen companies owning CDS on another company and in the position to profit if that company goes bankrupt, it provides an incentive for that company to go bankrupt. This is why there is a concept in life insurance called "insurable interest," which basically means that you can't buy insurance on just anybody. If you could buy life insurance on anyone there would be severe moral hazard as you could profit if that person dies (which leads to a big mafia business in ensuring the policy is collected on, if ya know what I mean).

Our four largest banks are the biggest issuers of these derivatives and are so interconnected into our financial system that one failure would collapse them all. We must extricate these banks from these types of transactions and only allow non-systemic companies to issue such derivatives. We must make our banking system smaller and our banks should not be acting as investment banks - Glass-Steagall 2.0 needs to be imposed.

Finally, we need to do something about the top bank, The Federal Reserve. It has accumulated to much power and used it in non-transparent ways, accomplishing the exact opposite of its founders intentions (actually its accomplishing everything its founders intended, just not what they sold it as). The Fed has not stopped the formation of bubbles or lessened the boom-bust cycle, in fact it has made it worse and devalued our currency in the process.

Bonuses and executive compensation are important, but they are shareholder issues and thus the best way to address them is to address the bigger issues and get the government out of owning the financial system (but regulating it....which they haven't proved able to do) and give the power over executive compensation back to shareholders (where it hasn't been....partially due to mutual fund ownership).

We continue to spend our time and outrage over bonuses that seem huge (and they are) but are pennies compared to the larger issue of derivative time bombs (we are talking billions versus trillions).

My Starbucks Frappachino now costs 6% more ($.25) as of last Thursday.....is this a sign of inflation or the taking advantage of an addict?

In my previous column I talked about Deflation and Inflation, the linked to article does a great job in explaining the Inflation issue.

"Most notably, deflation's advocates point to falling prices for certain goods, such as cars, clothes and hotel rooms, as evidence that the general price level is falling. The problem at first glance is that falling prices in isolation are not evidence of deflation.

Consider hotel rooms in New York City. Relative to three years ago, they've become much cheaper. But far from evidence of deflation, falling hotel prices merely expand the range of goods visitors to New York can purchase. If hotel rooms cost $200 less per night, tourists by definition have $200 more to spend on other goods previously out of reach. The impact on New York's price level is zero."

Friday, October 16, 2009

Ann Lee is echoing what I said in my previous post (or am I echoing her?) about the financial sector, I encourage you to read this short opinion piece.

The banks have no incentive to lend. Most of them still have a significant amount of bad loans sitting on their books that they don't want to recognize as nonperforming. If the banks recognize these bad loans, all the write-offs may force them into bankruptcy. Instead, they hope that over time renegotiated loan terms will eventually allow the borrowers to make their payments. This ordeal could last at least a decade if this cycle is similar to other crises, like Japan's lost decade of the 1990s. As the fed funds rate goes to zero and existing loans in technical default continue to sit in bank portfolios, why should banks make new loans when they can make money for free with the government? There is no longer a stigma associated with borrowing from the Fed, so banks can earn a huge spread by borrowing virtually unlimited amounts for nothing and lending that same money back to the Treasury.

Bonuses on wall street are about to set a record according to the wall street journal, potentially $140 Billion. Some people are not happy about this, count me one of them. On the other hand I'm not real big on government telling private businesses how much they can pay their employees - that is the job of the shareholders. Which brings me to my point - WE OWN WALL STREET. Wall street would not exist without the American people and the massive government bailouts of the past two years. I'm a capitalist at heart, however we do not have capitalism in our banking and financial services sectors, we have a hybrid of Capitalism and Socialism where bank profits goes first to the elitists running the company, then to the shareholders but big losses accrue to the taxpayer. This is the same thing that happened with Fannie and Freddie - there is a moral hazard that companies that know they can't fail will take on extra risk in order to obtain extraordinary profits and that risk is financed with low interest rates by institutions who also feel the government will bail out these institutions (and hence themselves) if anything ever went wrong. Why do you think so much effort was made not to wipe out the bondholders or at least force the bondholders of these large firms to take the first losses, instead of the taxpayers? There is a wink and a nod that if you can build your company to be so big and intertwined that you will not be allowed to fail - this is at the heart of our financial problems.

So when Wall Street is patting themselves on the back for a job well done, when the reality is that they have helped to destroy the very fabric of America (along with their friends in the government) the rest of America settles in to whether the first depression since the Great One. We have 17% unemployment and Goldman Sachs is set to pay on average over $500,000 per employee in bonuses. Goldman Sachs would not be standing today without the government bailouts of AIG, TARP and the allowance of them turning into a bank holding company. Privatization of profits, socialization of losses is not capitalism and it will destroy our financial system (it already did, its now on life support and in reality needs a blood transfusion).

Capitalism is based on failure, without failure there is no capitalism - just socialism and communism. Our financial services sector needs a massive amount of reform. If a company wants to pay huge bonuses, great, I encourage that and am happy for the people who receive those bonuses.....as long as those bonuses are based on an insurance policy that WE have to pay out on when that company fails. We don't need a pay czar, we need to separate out institutions that are too big too fail and break them up. We need to have rules for entities that rely on the government (FDIC deposit institutions) and rules for those that don't and be firm that the USA will no longer come to the table and bail out companies when they get into a mess. We need to ensure that if they do overleverage that it will not cause taxpayer bailouts.

I've got so much more to say on this, but I think you get the point - being against Bailout Bonuses is not anti-American, its pro-America - we must destroy To Big To Fail to save a country that the world knows is too big too fail.

Thursday, October 15, 2009

"They were the worst three months of all time," said Rick Sharga, spokesman for RealtyTrac, an online marketer of foreclosed homes.

During that time, 937,840 homes received a foreclosure letter -- whether a default notice, auction notice or bank repossession, the RealtyTrac report said. That means one in every 136 U.S. homes were in foreclosure, which is a 5% increase from the second quarter and a 23% jump over the third quarter of 2008

Wait till the $8,000 credit expires and the effects of the 90 day foreclosure moratorium in California coming to end start showing up in the numbers, not to mention the resets that are in their infancy. The current foreclosure crisis is much worse today than ever before, yet you wouldn't know it by the way the bank stocks and the stock market is trading.

You won't hear this from any other source, the current bull market is destroying retirement savings.

But the market is up over 50% from its March lows, this is good isn't it? Well for those who managed to stay in stocks or switch back to stocks at some point since March this rally has been impressive and great for a person's retirement savings (unless of course things fall apart again). Today, stocks are now trading at around 20 times trailing 10 year Price/Earnings, whereas in March they were at around 12. Research shows that the higher the P/E you pay, the lower your returns over the following 20 year period. In other words retirement participants could have expected more money in retirement if they were given more time to invest at the March lows. Let's pretend the market stayed where it was at in March of 2009 and slowly rose over the next 20 years - retirement plan participants who have money taken out of their paychecks would be investing at much lower prices and thus could expect a higher rate of return. Now that stocks have risen to full value (many would argue they are overvalued) the return that can be expected is much less (and the downside much greater). In other words, this quick rise in stocks destroyed one of the best opportunities for retirement plan participants to create wealth for their retirement, by investing at low prices (remember, buy low, sell high!).

If this Bull market has done anything it has perhaps bailed out some investors who can now sell into the market and reduce their risk exposure to what is more appropriate for them. Hopefully a lot of investors are able to take advantage of this, but retirement plan participants who need to contribute for the next 20 years should be hoping that stocks fall, giving them the ability to accumulate at reasonable prices - which will create much more wealth for them in the future then this current bull.

Tuesday, October 13, 2009

It seems like I keep coming back to this theme - are we in for Inflation or Deflation? In past blogs I've argued for both and favored the Inflation view. I'd like to update you on my current thinking, which is to say I still don't know the future and the present is getting tougher and tougher to figure out. I like to style myself as somewhat contrarian, thus when I was buying TIPS (Treasury Inflation Protected treasury bonds) back in November when everyone else thought we were entering a deflationary cycle, yields were over 3% real. I've written a lot about the printing presses of the Federal Reserve and the devaluation threats we face with a currency that is overleveraged and increasingly increasing in the amount available. I've stated that Inflation is the real threat. I still believe inflation is a huge threat, however the consensus view has now changed to agree with me and that makes me question whether I am right. Its not that the consensus is always wrong, its just wrong often enough to scare me when I'm in the consensus.

So here is the Inflation story in a nutshell:

The Federal Reserve is printing money faster than at anytime in history (that I'm aware of)

That printing of dollars leads to more dollars, whenever you have more of something it is worth less

Worth less dollars quickly become "worthless"

$1 in 1800 would buy you MORE in 1913 (50% more) than in 1800, In 1913 the Federal Reserve was created and today the dollar buys 99% less (its worth the equivalent of 8 cents in 1800 dollars, I say 99% percent because the dollar peaked at $2.04). See Sean Malone's Rise and Fall of the Dollar

We have a history (other than the Great Depression) since the Federal Reserve was created of inflating our currency.

The United States is in a debt spiral, our National Debt is approaching $12 trillion, or annual deficit will be $1.6 trillion this year and our off-balance sheet debt is between $50 and $105 trillion depending on who is counting it.

With all this debt there is no choice but to inflate the currency and "inflate our way out of this mess"

Essentially this is the conventional wisdom. I actually believe most of this and think that long term, inflation is a huge threat.

But what of deflation? Are we seeing inflation right now?

Gas prices are going up, but are still lower than a year ago

Home prices are lower and despite what the media says, going lower or stagnating

Restaurants haven't raised prices and I'm getting much better deals when I go (I see more Happy Hour's!)

Cars are not significantly cheaper, but they aren't rising in cost (okay, they were cheaper when subsidized with Cash for Clunkers)

My Internet, Cable and Phone are cheaper and I have more services

Wages are not going up, they are dropping and people are taking pay cuts or forced furloughs (or being fired)

Airline tickets are not higher (even with higher oil prices)

Hotel prices are not higher, they are much lower in some cases

My point? We are now experiencing deflation, despite the best efforts of the Federal Reserve. The only place we see inflation is in commodities and asset prices (Gold, Stocks, etc). Right now deflation is winning. If you're looking for a model where a country printed lots of money and didn't experience inflation......look no further than the second largest economy in the world - Japan (for now at least).

How could we have deflation with so much money being printed? The money is not being put to work. There is a tremendous demand for safety right now and U.S. citizens are putting their money into banks, who are not lending the money out (which creates reserves and excess reserves). This huge demand lowers the amount of interest a bank must pay (supply and demand always win out).

What many are leaving out of the inflation debate about printing money is Velocity of Money. Though some recent research points out that its the banks creating money, not the federal reserve that leads to excess reserves and more Fed printing, I'm not yet convinced. Here is the simple explanation. The Fed prints money and that money sits on deposit with the banks, but if the banks don't lend that money out (which they are not because their balance sheets are impaired and they are scared of the marketplace right now (self-fulfilling prophecy)) the money doesn't circulate and multiply. Velocity is simply a measurement of how often a dollar gets recylced through the system. If an individual applies for a loan to buy a car and that loan is granted then $30,000 is lent to buy the car and is deposited into another banks account, creating new money (this is called fractional reserve banking), if that bank decides to lend that money and there is a borrower worthy, the money continues to circulate and more and more money is created (sounds weird and my explanation is terrible). The point is that if people aren't spending and if banks aren't lending, there is no velocity and thus no leveraged money creation.......no inflation.

To be fair, the inflationists (of which I am one, but I'm also a deflationist....how do you like that!) don't believe we are in an inflationary cycle now, but that if banks become more confident and put those excess reserves (which are massive) to work and start lending again we could see a bubble even bigger than before as banks routinely will leverage themselves by a factor of 12 - 20 (meaning that for every $1 the Fed creates, the banks turn it into $12 or $20), this would lead to mass inflation.

If you're confused, don't worry, you are supposed to be. The government and Federal Reserve have set up a system that is absurd and the more you don't want to know about it, the easier it is for them to get away with just about anything.

Many will argue that the Fed's goal is to inflate our way out of this massive debt we've accumulated and they are right to an extent. China is nervous as are other countries which is why the dollar has been falling, but make no mistake, the dollar is still king....for now. In a panic, people will clamor for dollars (unless of course that panic is induced by a mass devaluation). Believe it or not the $12 trillion is not our biggest problem. A problem it is and it must be addressed, however the real problem is the one that CAN'T be inflated away - Entitlements. Social Security, Medicare and Medicare Part D (not to mention Medicaid) are REAL obligations, meaning that the value can't be inflated away - the only way to reduce these deficits is to raise taxes (by a lot) or reduce benefits (actually technology can also reduce these costs.....as well as increase them).

We have a huge debt problem and if not faced head on and soon, it threatens our way of life and that of our children and grandchildren.

We are in a depression right now and deflation is winning the day. How long this will last, I don't know, but we need to be prepared for both scenarios.

Thursday, October 08, 2009

As if this is going to come as a surprise, the FHA is in need of a bailout and guess who's going to provide it?

It didn't take a rocket scientist to know that this was coming, the FHA has become the new subprime lender in this country offering loans that are effectively 100% (no down payment loans) and many times the loans are made to people with less than perfect credit. The FHA even has a refinance program that allows a refinance up to 125% of LTV (loan to value) and I've been told there is no credit check for this if the refinance is being done on an FHA existing loan.

Housing is continuing to kill the economy and the current programs to address it are not working (modification, monetization and more sub-prime type lending). We need a real solution, its starts with sound lending, sound money and a program to put an end to the foreclosure/mortgage crisis that is worse today than it was a year ago.

Tuesday, October 06, 2009

So you made several hundred million from predicting the subprime massacre, what do you do for an encore? Kyle Bass runs Hayman Advisors, a hedge fund that did quite well during the downturn (though is down 17% this year) and he believes we are in for massive amounts of inflation, globally. I don't expect you to read his 24 page quarterly report, but I actually sat down with a cup of coffee and did.....its not pretty. If you thought the US was printing money, you should see China (and Japan). The world is attempting to recover from last year's devastation by reflating and printing money. The global economies are responding to over-leverage by......adding more leverage.

Monday, October 05, 2009

As I've tracked the Federal Reserve's operations this summer I've become increasingly uncomfortable with what I saw. Instead of writing what would turn out to be a highly technical and probably boring piece about debt monetization, failed treasury auctions and open market operations I'd like to point you to a piece by Graham Summers that I think explains my concerns, you can click on the title above to access the entire piece, I'll give a few tidbits below:

For the Fed to hint at raising rates (let alone raise them) would kick off a systemic implosion that would wipe out the very guys the Fed has been bailing out. Suffice to say the Fed won’t be raising interest rates now or anytime too soon (within the next 3-5 years, unless inflation destroys the dollar).

The Fed also announced it would be slowing its purchase of Mortgage-Backed Securities (what I call the Fed’s “cash for trash” program). The Fed has stated previously that it will buy $1.45 trillion in mortgage-backed securities from US banks and that this program will end by the end of 2009. However, last week the Fed said it will be extending the program (but not the amount of money spent) until the first quarter of 2010.

The Fed did announce that it would let its Quantitative Easing program end in October. If you’re not familiar with this program, it’s basically a fancy way of saying that the Fed has been buying US debt in order to finance Obama et al’s massive deficit.

This particular development is key. A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!

The Fed’s purchases outnumber foreign holders (foreign governments), US households, and Primary Dealers (mega banks) combined. One should also note that foreign holders reduced their purchases of US debt from $159 billion in 1Q09 to $101 billion in 2Q09 (a 40% decrease).

In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter.

I’ve often stated that the Fed will have to sacrifice stocks or the US dollar. If the Fed does in fact end Quantitative Easing in October (as it has stated it will in last week’s FOMC), then we’ll see what the market really thinks of US debt as an investment class. It’s clear from the above data that foreign holders want higher rates (yields) in order for them to start buying more heavily. However, as I’ve stated before, the Fed cannot afford higher interest rates without blowing up US banks.

The Fed is no longer walking a tightrope, it is now attempting to keep the box it is standing on front tipping over....which would tighten the noose around its next and....well you know how that ends. The rope is no longer what the Fed is walking on, its what is around their neck.